Trading Basics: Evolution of a Trader

CHAPTER 3

Do Stops Work?

In the last chapter, we tested scaling in and out that used stops and made some preliminary conclusions about them. In this chapter, we take a closer look at stops, continuing to follow the money.

What is more important, making money or limiting losses? If you answer both, thinking that this is a trick question, you could be right. Both are important. If you do not make any money then what is the point of investing or trading the markets? If losses grow without bounds then your portfolio could be seriously hurt. Here is why.

Imagine that you have a portfolio worth $100,000 and you spend it all buying AToothpick.com because you heard from your best friend who talked to the janitor who no longer works there that the company has a new widget coming out. The stock climbs on the rumor and the value of your portfolio skyrockets to $150,000. On paper, you have made 50 percent!

A few months later, news comes out that their new widget was a flat metal toothpick that rusted not only in the box, but in your mouth as well, and sales are, well, flat. The stock drops 50 percent. That is the same move going down (50 percent) as it was going up, but your portfolio is now worth just $75,000. A portfolio that drops by 50 percent will take a 100 percent move to get back to breakeven. Based on this analysis, controlling losses is more important than making money.

Table 3.1 shows the numbers. If you suffer a 20 percent loss, it will take a 25 percent gain to make you whole. ...